January 23, 2018

It’s pretty clear that the major agricultural trading firms, notably the ABCDs–ADM, Bunge, Cargill, and Dreyfus–are going through a rough patch of tight margins and low profits. One common response in any industry facing these conditions is consolidation, and in fact there is a major potential combination in play: ADM approached Bunge about an acquisition..

I am unsatisfied with most of the explanations given. A widely cited “reason” is that grain and oilseed prices are low due to bumper crops. Yes, bumper crops and the resulting low prices can be a negative for producers, but it does not explain hard times in the midstream. Ag traders do not have a natural flat price exposure. They are both buyers and sellers, and care about margin.

Indeed, ceteris paribus, abundant supplies should be a boon to traders. More supply means they are handling more volume, which is by itself tends to increase revenue, and more volume means that handling capacity is being utilized more fully, which should contribute to firmer margins, which increases revenues even further.

Greg Meyer and Neil Hume have a long piece in the FT about the potential ADM-Bunge deal. Unfortunately, they advance some implausible reasons for the current conditions in the industry. For example, they say: “At the same time, a series of bumper harvests has weakened agricultural traders’ bargaining power with customers in the food industry.” Again, that’s a flat price story, not a spread/margin story. And again, all else equal, bumper harvests should lead to greater capacity utilization in storage, logistics, transportation, and processing, which would actually serve to increase traders’ bargaining power because they own assets used to make those transformations.

Here’s how I’d narrow down where to look for more convincing explanations. All else equal, compressed margins arise when capacity utilization is low. In a time of relatively high world supply, lower capacity utilization would be attributable to increases in capacity that have outstripped gains in throughput caused by larger crops. So where is that increased capacity?

There are some hints of better explanations along these lines in the FT article. One thing it notes is that farmer-owned storage capacity has increased. This reduces returns on storage assets. In particular, when farmers have little on-farm storage they must sell their crops soon after harvest, or pay grain merchants to store it. If they sell their crops, the merchant can exploit the optionality of choosing when to sell: if they store at a local elevator, they pay for the privilege. Either way, the middleman earns money from storage, either in trading profits (from exploiting the timing option inherent in storage) or in storage fees. If farmers can store on-farm, they don’t have to sell right after harvest, and they can exploit the timing options, and don’t have to pay for storage. Either way, the increased on-farm storage capacity reduces the demand for, and utilization of, merchant-owned storage. This would adversely impact traders’ margins.

The article also mentions “rivals add[ing] to their crop-handling networks.” This would suggest that competitive entry/expansion by other firms (who?) is contributing to the compressed margins. This would in turn suggest that ABCD margins in earlier years were abnormally high (which attracts entry), or that the costs of these unnamed “rivals” have gone down, allowing them to add capacity profitably even though margins are thinner.

Or maybe it’s that the margins are still healthy where the capacity expansions are taking place. Along those lines, I suspect that there is a geographic component to this. ADM in particular has its biggest asset footprint in North America. Bunge has a big footprint here too, although it also considerable assets in Brazil. The growth of South America (relative to North America) as a major soybean and corn exporting region, and Russia as a major wheat exporting region, reduce the derived demand for North American handling capacity (although logistical constraints on Russian exports means that Russian export increases won’t match its production increases, and there are bottlenecks in South America too).

This would suggest that the circumstances of the well-known traders that have more of a North American (or western European) asset base are not representative of the profitability of grain trading overall. If that’s the case, consolidation-induced capacity “rationalization” (and that’s a major reason to merge in a stagnant industry) would occur disproportionately in the US, Canada, and western Europe. This would also suggest that owners of storage and handling facilities in South America and Russia are doing quite well at the same time that owners of such assets in traditional exporting regions are not doing well.

So I am not satisfied with the conventional explanations for the big ag traders’ malaise during a time of plenty. I conjecture that the traditional players have been most impacted by changes in the spatial pattern of production that has reduced the derived demand to use their assets, which are more heavily concentrated in legacy production regions facing increased competition from increased output in newer regions.

Ironically, I’m too capacity constrained to do more than conjecture. But it’s a natural for my Université de Genève students looking for a thesis topic or course paper topic. Hint, hint. Nudge, nudge.

Very good piece on the ABCD’s and the margin crunch.
Good to see some honest points rather than the normal slop about big crops and low margins. Having been a Trader for 32 years prior to getting into academia, I concur with you that the excuse that big crops are spoiling profits margins is totally bogus.
All else being equal, Big crops have always resulted in big margins and small crop reduced margins.

Regards,

Jay O’Neil
Senior Agricultural Economist
International Grains Program
Kansas state University
Manhattan, KS

This sort of many-supplier-to-many-customer commodity market is one of the applications that smart-contract blockchain promoters tout as a candidate for disintermediation. (There appears to be an attempt to do this with coal, called Coalcoin….Barleycoin, anyone?) I doubt anyone has a working blockchain solution scaled up anywhere near the size required to impact the big traders’ margins yet, but maybe the prospect of such is attracting investment in competitors and in farmer-owned storage. Because blockchain technology is just so hot these days, y’know.

I don’t know ag well; with that caveat a few things I’ve seen in my corner.

Have to imagine they lean on spec trading for margins. Spec business isn’t going to print in a flat, low market.

At least one, perhaps more, of the companies mentioned loves term customer deals. Fat margins and information flow feeds to the spec books. Term activity tends to dry up in a low vol market; no one cares about getting de-risked if they don’t perceive their to be risk (after all, why buy food if you’re not hungry…?)

In my corner of the business, cheap money over the past five years is crushing cash volatility. Marginal projects got built that are now online and driving down spreads. Analog: very cheap to build pipelines, you get them at relatively low absolute prices, keeping prices/spreads low (since it’s easy for new supply to reach market instead of needing big spreads/fixed price levels to be in the money). Same may be holding in ag.

Finally, a lot of people think the great commodity boom level margins were long-term sustainable. They’re casting around for something that will get the good times rolling once again even though the underlying market isn’t there.

Farms are becoming professional (old news). There are many different options available for farmers looking to store their crops (old-ish news). Farmers are a sponge for market information (news as old as farming). Much arable market information, certainly enough for most farmers’ needs, is freely available over the internet.

Smallholders in Uganda producing coffee, say, get taken for a ride by local merchants because they lack storage and in many cases lack good market information (also the other endemic problems). Farmers in the west often get to take their merchants for a ride, or so the merchants complain, and at the very least they have the capital to invest in storage and access to commodity market info.

Transparency and a balance of power in a market does seem to reduce trader margins across several (all?) commodities. Perhaps an inevitable step along the road?